The Realpolitik of Using MCEV in Asia

The Realpolitik of Using MCEV in Asia

A Potential Way Forward for Embedded Value Reporting in Chinese Taipei and

Elsewhere in the Region

Simon Walpole &

Ophelia Au Young

Joint IACA, IAAHS and PBSS Colloquium in Hong Kong www.actuaries.org/HongKong2012/

Session Number: TBR3



Agenda

1. Quick definition of TEV, EEV and MCEV

2. Why is it difficult for Chinese Taipei to move to EEV or MCEV?

3. A potential way forward for EV reporting in Chinese Taipei


1. Quick definition of TEV, EEV and MCEV



TEV versus EEV

NAV

PVFP

Traditional EV

Cost of “Lock-in”

NAV

PVFP

EEV

“Lock-in”

Cost of Options & Guarantees



NAV

PVFP

EEV

“Lock-in”

Cost of Options & Guarantees

PVFP

MCEV

Cost of Financial Options & Guarantees

Cost of Residual Non

Hedgeable Risks

Frictional Costs of Required Capital

Free Surplus

VIF

NAV

Required Capital



6

2. Why is it difficult for Chinese Taipei to

move to EEV or MCEV?



Example 4 – WP Endowment Comments Recent History of Interest Rates in Chinese Taipei

Source: TII data



Negative Interest Spread

3.00%

3.50%

4.00%

4.50%

5.00%

5.50%

6.00%

6.50%

7.00%

7.50%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Average Guaranteed Rate of InterestPremium Income Basis (NOT reserve basis!)

6.9% 6.7% 6.0% 5.9% 5.7% 5.5% 5.2%

0.0% 2.0% 4.0% 6.0% 8.0%

10.0%

Shin Kong Life

Cathay Life

Taiwan Life

China Life

ING PCA Life Fubon

Estimated required yield on the Legacy block

Source: TII Data and JP Morgan estimates

Source: TII data and knowledge of the level of interest rate guarantees in each year



Liability & Asset Duration Mismatch

About Age 25

Source: Deloitte’s projection using a sample Chinese Taipei life company



Guaranteed Health Products

0%

5%

10%

15%

20%

25%

30%

35%

% of First Year Premium Income (Y1) in Health Products

Source: TII Data



Profits: Experience over 10 Years from 1994

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Earned Rate Guaranteed Rate

-

0.0020000

0.0040000

0.0060000

0.0080000

0.0100000

0.0120000

0.0140000

0.0160000

0.0180000

30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60

90% of89TSO

1994

1997

2000 0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

Y1 Y2 Y3 Y5 Y10

1993

1996

1999

2002

0.00%5.00%

10.00%15.00%20.00%25.00%30.00%35.00%40.00%45.00%50.00%

1994 1997 2000 2003

Initial Expenses as % of FYP Renewal Expenses as % of RP

Source for all charts: Deloitte’s presentation at 5th CEO Summit



Profitability: Sensitivity

Source: Deloitte’s study using a sample Chinese Taipei life insurance company

-150.0% -100.0% -50.0% 0.0% 50.0% 100.0% 150.0%

4% Investment Return



Impact on VIF before CoC


-200.0% -150.0% -100.0% -50.0% 0.0% 50.0%

20% Tax

250% RBC

300% RBC

Impact on VIF after CoC

300% RBC

250% RBC





-15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0%

Impact on VIF before CoC

Expense

Lapse

Mortality and Morbidity

RDR

- 10%

- 10%

- 10%

- 100 bps

+ 10%

+ 10%

+ 10%

+ 100 bps


Profitability: Sensitivity



As at 31.12.2010Cathay Shin Kong Fubon China Life TW Life

Published Results (NT$BN) ANW 193.00 148.50 81.90 48.10 12.134 VIF before CoC 338.00 62.30 114.50 36.00 21.159 CoC -82.00 -34.80 -40.90 -12.96 -6.119 VIF 256.00 27.50 73.60 23.04 15.04 EV 449.00 176.00 155.50 71.14 27.18 VNB 43.00 12.60 24.80 6.88 4.27 Method & Assumptions Method TEV TEV TEV TEV TEV

RDR (VIF)

RDR (VNB)10.00%10% 10.50%11.00%10.00%

Source: company’s published EV disclosure

Summary of Recently Published EV Results



•EEV/MCEV is lower relative to TEV due to the explicit allowance for the time value of options and guarantees •We have assumed that MCEV produces a higher TVFOG than EEV •At point of sale, TVFOG = 20 for EEV and TVFOG = 40 for MCEV •Assume uniform “run-off” of TVFOG over duration of policy •The extent of the reduction will depend on:

– The size of the free estate – if large free estate then lower shareholder cost – Management decision rules in respect of bonuses and policyholder behaviour in

respect of lapses in different scenarios and asset dynamic asset mixes – Different approaches and assumptions used for EEV and MCEV

Recent Transaction Prices

Fubon/ING Aegon/Meifu NanShan / Ruentex

Metlife / Chinatrust

Published Results (NT$BN)Announcement Date Oct-08 Apr-09 Feb-11 Oct-11Transaction Value 19.50 2.73 64.80 5.30Stated Book Value 27.33 4.65 148.04 9.80Price/Book Value 0.71x 0.59x 0.43x 0.55x

Assume that Transaction Value = Appraisal Value = Embedded Value + Value of Future New Business Assume that Value of Future New Business > 0 So Transaction Value > Embedded Value > Book Value + VIF But Transaction Values < Book Value Means VIF < 0

Source: internet information



3. A potential way forward for EV

reporting in Chinese Taipei



Issues with TEV in Chinese Taipei – Methodology

• Investment return assumptions

• Objectivity difficult to demonstrate

• Risk margins capitalised (riskier assets => higher EV)

• Allowance for risk

• Cost of options and guarantees not fully recognised

• Same RDR for all product types

• Cost of capital limited to 200% RBC



Issues with TEV in Chinese Taipei – Credibility

• EVs more optimistic than implied EV in actual life company transactions

• Many transactions

• Implied VIF negative in every case

• VIF in published EV positive in every case

• Are transacted companies different from those with published EVs?

• EVs higher than market capitalisation in some cases

• Observed over several years in some cases

• But market cap is for whole listed Group, not just the life insurance entity…

• Other studies suggest that EEV or MCEV would be lower



Issues with TEV in Chinese Taipei – International Benchmarking

• TEV has disappeared in some places:

• Europe, where EV was invented

• South Africa

• It seems to be disappearing from some places in Asia:

• Japan

• It is still widely used in some places:

• China – but there the reasons for holding back from EEV or MCEV do not (in general) include concern over the result

• Australia – but there is evidence that the result would not be much different EEV or MCEV



Issues with TEV in Chinese Taipei – Local Benchmarking

• IFRS4 Phase 2

• Government has stated a desire to “align with international reporting standards”

• Impact study being carried out now

• Solvency capital

• Government has stated a desire to “align with international reporting standards”

• AA cash flow testing now stochastic, being enhanced every year

• EV

• No changes



Issues with TEV in Chinese Taipei – Objectivity

• Written standards

• CFO Forum standards only started with EEV

• No local standards

• Reliance on independent sign-off – but independent reviewers desire objective standards too

• Disclosures

• Current public disclosures vary widely

• CFO Forum disclosures very comprehensive



Issues with TEV in Chinese Taipei – Other

• Practicality

• Stochastic methods now standard in Chinese Taipei

• Understandability

• Some complaints about MCEV

• Not so many about EEV

• Are analysts & investors really asking for this?

• They don’t talk about it much

• Market cap situation => EV adjustments are downwards

• High awareness of implied VIF figures in transactions

• Overseas analysts & investors do ask overseas companies



Options: Overview

Methodology

Written Standards & Disclosures

Timing

Status Quo TEV

Progress EEV

International Best Practice MCEV

Status Quo None / Elementary

Progress Local Guidance

International Best Practice CFO Forum-style

Status Quo Wait until someone asks

Progress Investigate then judge

International Best Practice Do it ASAP



Methodology: Keep the Status Quo

• There is a credibility risk in keeping the status quo

• Results not consistent with market observables

• Objectivity of assumptions can be challenged

• Benchmarking internationally becoming more difficult

• Benchmarking locally becoming more difficult

• Reliance on independent sign-off could become restricted

Methodology

Status Quo TEV

Progress EEV




Methodology: Going to MCEV

• Results would be much more dependent on non-controllable risk

• Without a high “liquidity premium”, the VIF would be very negative

• Even with a high “liquidity premium”, the VIF will be very volatile

• In the short term, unlikely to be much pressure to move to full MCEV

• Full MCEV is still evolving anyway

• Pressure to improve on TEV is not immediate, so there is time to move to MCEV later if necessary

Methodology

Status Quo TEV

Progress EEV




Methodology: Something in Between

• Only viable medium-term option

• Helpful flexibility within EEV approaches

Methodology

Status Quo TEV

Progress EEV





• There are various risks in keeping the status quo

• Little disclosure could lead to questioning of credibility (IFRS4 will have more?)

• Pressure from regulator

• Pressure from independent reviewers

• Benchmarking internationally shows differences

• This is a good longer-term aspiration

• Standards should match chosen method; if EEV, can refer to first draft CFO Forum principles

• Factual disclosures should follow best practice

• Disclosures around results require understanding, and understanding can require time




• Standards should be developed locally, with reference to international best practice (eg IFRS4, RBC)

• Requires a working group to draft, then energy to discuss and agree



Timing




• It is not clear when EEV will be demanded, but… • …sooner or later China will move to EEV or MCEV

• At the latest when they start buying European entities • The impact on their EV will be less than on Chinese Taipei EVs, so they can

implement more quickly • In Chinese Taipei:

• Question of moving to EEV (or MCEV) is “when” not “if” • Implementation date = earlier of:

• Demand from regulator, analysts or independent reviewers • When companies are confident about the results

• Investigation start date = as soon as possible



Our Proposal for Chinese Taipei

Methodology


Timing

Status Quo TEV

Progress EEV








Working Group should start as soon as possible



Our Proposal for Chinese Taipei – Methodology

• EEV following the original CFO Forum principles • Top-down RDR is fine: RDR = risk-free + 2.5% (?) • “Direct” approach but only for main portfolios



Our Proposal for Chinese Taipei – Methodology: EEV

• Deterministic approach for products with no guarantees

• Stochastic approach for TVFOG of products with embedded future options & guarantees

Cash Flows

European EV (“EEV”)

Economic Assmpns

Deterministic

• Same as TEV

Stochastic

• Simulations based on real world assumpns

• Must be internally consistent but not necessary market consistent

European EV (“EEV”) Non-Econ Assmpns

Deterministic

• Usually as per

TEV

Stochastic • Dynamic

lapse and take up assumpns allow for p/holder behaviour for products with gtees

• May also allow for dynamic mangment behaviour


TVOG

• Stochastic valuation of time value of options & guarantees captures:

– Mangmt behaviour

– P/holder behaviour

– Cost of s/holder capital injections

• Assumptions used not necessarily market consistent

• Similar to TEV, constant RDR set equal to risk free rate plus a risk margin

• One exception is that the risk margin no longer contains an allowance for the cost of options & guarantees, as there is an explicit allowance for those in the calculation


Discounting

European (“EEV”)

Cost of Capital

• Required capital needs to consider both – Amount

required by regulators, and

– Amount required by internal measures

• Cost of lock-in defined as per TEV



Our Proposal for Chinese Taipei – Investment Return & Capital

• Investment return assumptions

• Use the stochastic cash flow testing assumptions

• Brings in objectivity, easier disclosure

• Live with the fact that risk margins are capitalised (riskier assets => higher EV)

• This was part of the original EEV approaches, so can be explained as part of “Chinese Taipei’s transition”

• Allowance for risk • Continue to use 200% RBC

• Objective, easier disclosure • Only consistent with CFO Forum disclosures if companies state that

“amount required by internal measures” = 200% RBC



Potential Impact on Results

Product Move from TEV to EEV

Compulsory Dividend

Traditional Non Par

Traditional True Par

Interest Sensitive Annuities

Universal Life

Unit Linked

Variable Annuities

Riders

TOTAL VIF

?



Practical Approach

1. Set up an EV Working Group (two streams: methodology & disclosures) on an industry-only basis (but with reviewers)

2. Start with the original CFO Forum EEV methodology, on a top-down, partially-indirect basis

3. Use the stochastic cash-flow testing assumptions and RDR = risk-free + 2.5%, and investigate the results

4. Understand the results, focus on drivers and main influencers on the results – go bottom-up, fully direct?

5. Finalise a medium-term approach with transition plan (over n years, where n is 3+)



Elsewhere in Asia



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The Realpolitik of Using MCEV in Asia

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